Risk Coverage - Hydropower Development

Overview

Every infrastructure development entails a range of uncertainties and risks, some inherent in the nature of the development undertaken and others resulting from the manner in which the development is carried out and financed. Risks increase with procedural remoteness from the project; they can be better contained if the development remains in public hands than they can be where a private developer or investor has to interface with the public sector.

Hydropower development is, on the whole, not considered to be a speculative venture so that risks are to some extent offset by the normally long-term stability of the energy resource.

Risks can be classified under:

• common risks shared equally between the public and the private sector and depending largely on the nature of the development, and
• interface risks specific to a private developer working with or licensed by the public hand

Common Risks

Project Preparation

Water Availability

First among the risks facing whoever promotes and ultimately owns the scheme are those involved in the conception of the project. The greatest risk in the hydro case concerns water availability. Water resources for small schemes have usually been only cursorily surveyed; flow measurements have extended over only a short period of time and may not have captured multi-annual cycles. Even longer-term records offer no assurance that the hydrology will not change, often drastically, cyclically or even permanently. Network interconnections or standby diesel plant may offer some relief from critical power shortage - at extra cost. Stand-alone schemes may suffer greatly and furnish an unreliable supply. Economic appraisals of the merit of a given scheme have to take such eventualities into account and provide an appropriate justification for whatever standby arrangements may be considered necessary. Supply interruption leading to appreciable amounts of unserved energy can be very costly for both supplier and consumer.

Surface and Subsoil Conditions and Seismicity

Risks associated with surface and subsoil conditions and seismicity should likewise be fully evaluated in the planning stages of a project but, here again, shortage of development funds may have led to shortcuts in project preparation, at the price of sometimes greatly increased civil engineering effort during construction and corresponding cost overruns. Although small schemes are perhaps less sensitive to subsoil conditions and local strengthening can often be readily accomplished, major mistakes have been made and major cost overruns experienced.

Market-related risk

Many schemes, especially stand-alone plants, have to face a market-related risk.

Even in cases where a careful market survey has been carried out, there may be uncertainty on:

• the availability of an effective transmission interconnection with the network of the load centres;
• the precise extent of the potential market;
• the development of the market once energy becomes more freely available;
• the price-demand resilience of the consumers which will be experienced when electricity is sold on commercial terms.

Unless there is room for water storage, hydro generation will be rigidly run-off dependent and offers little scope for adaptation to market requirements or for expansion of energy production. There is then danger of an ultimate mis-match of demand and production characteristics which may result in inadequate revenue recovery and unsatisfactory financial performance.

Construction

Inappropriate or Faulty Design

Risks of inappropriate or faulty design can arise where there is an interface and split responsibility between the designer and the constructor or where scarcity of funds has caused site investigations to be cut short. The risk can be contained through performance guarantees if the constructor is made responsible for the final design. Design problems are exacerbated if lack of funds causes the monitoring and supervisory activities during construction to be curtailed although construction funds may be held back unless funding agencies and investors are satisfied that the design is sound and the anticipated performance is likely to be achieved. The turnkey (design-construct) approach may offer some remedy since interfaces do not occur during the development process and only a single main contractor remains responsible throughout. He will be subject to output and performance guarantees as well as completion penalties.

Construction Cost Overruns and Delays in Completion

The same arrangement will help to overcome the risks of construction cost overruns and delays in completion. The comparative complexity of hydro construction makes such schemes prone to slippage during construction. Slippage is not necessarily related to the scale of the work and quite small projects can suffer from the complex interrelation between different activities in the construction phase. The risk is greatest where the proportion of imports is large and where the site is remote. Difficulties and delays are also often encountered at the points of importation of foreign goods and equipment but these can often be overcome if governments are prepared to facilitate importation. If government help is not effective, turnkey and other contractors may claim force majeure and renege on their guarantees.

Force Majeure Risk

There is thus a force majeure risk which has to be evaluated when a turnkey contract is placed; contractors may wish to pitch contract terms fairly widely whereas the developer and his financial backers will naturally wish the terms to be well constrained.

It has also to be recognized that force majeure may be claimed by contractors for any delays incurred which are not under their control, for example delays due to:

• faulty or inaccurate specifications;retarded approvals from whatever public authority may be involved;
• ineffective site management and coordination between non-turnkey contractors;
• construction problems arising from inadequate site data and faulty surveys;
• difficulties with locally contracted labour;
• obstruction from local interest groups due to environmental sensitivities;
• true 'force majeure' due to civil or military disturbance or to adverse natural events (floods, storms, earthquakes).

A turnkey contract does not therefore offer complete protection against delays in completion and cost overruns. Insurance cover may be needed in some cases.

Although turnkey contracts are often quoted as being of "fixed price" - indeed this is one of the advantages commonly attributed to turnkey deals - contractors frequently submit supplementary claims by way of contract price adjustment (CPA) on account of:

• changes in design or specification for which they are not responsible,
• unforeseen or unforeseeable problems arising during the construction phase,
• delays experienced which are outside their control.

Contract price risk

Developers may thus face a contract price risk which can have important repercussions not only on the ultimate construction cost but also on the economic merit of the project and on its profitability. The sums originally intended to cover the investment costs may not be adequate to meet the CPA as well, and a new round of financial negotiations may have to be embarked on, possibly in the face of considerable resistance from the parties providing the funds. The risk is not necessarily the same as that arising from construction cost overruns; it can result from the knock-on effect of perhaps relatively minor deviations from the original design or construction concept. It may be mitigated by very careful phrasing of the turnkey contract, a matter that often receives insufficient attention, if only because of the time, legal effort and costs involved in preparing a reasonably tight document. The ultimate remedy is of course to allow no CPA. If inclusion of a CPA clause in the contract becomes inescapable, it is essential to make adequate provision for arbitration.

Operation

Performance Risk

A performance risk may not be revealed until the plant has been running for some time. It may be caused by faulty design, construction or manufacture or by the use of inappropriate materials. An extended performance guarantee may not always be effective, particularly as defaults may not become evident for some years after first commissioning of the plant. Serious cases may have to go to arbitration, especially where contractor's guarantees are time-limited. Hydrology and market-related risks will also have to be faced throughout the operating phase as well as operational hazards such as flash floods or unexpected rates of sedimentation. Anticipated output targets may not then be achieved and the merit of the scheme may become seriously tainted. The risk will be greatest for the equity holder who is not protected by the conditional payback arrangements attending contributions of loan capital. Caution would therefore suggest that:

• the proportion of equity is kept low, at 10-30% of the total investment as already mentioned;
• holders of equity capital are permitted fairly liberal terms which provide some protection against possible shortfalls in revenue.

Every hydro scheme imposes its own particular conditions which have to be carefully assessed by the potential investor, as far as he is able to do so ahead of any operating experience with the particular scheme. Translation of experience from one scheme to another is not often possible.

Inflation

Construction costs of hydro plant are prone to price escalation because of the relatively long construction cycle. Many contracts for small plants, for which the construction cycle does not normally exceed 3 - 4 years, include a fixed provision for price escalation, or an appropriate contingency margin, and the contracts are therefore effectively of fixed price. Loan redemption payments will also be at a fixed rate. The inflation risk is then unlikely to affect the initial capital investment or the commitments arising from it unless there are significant contract price adjustments to contend with. Operation and maintenance expenses, though small in the hydro case, will be exposed to general price escalation and so will be any future expenditure on major repair and rehabilitation. The latter, being capital cost items, are financially the more important. The risk of escalation of costs to which this expenditure is exposed is likely to far outweigh any provision for self-financing of future expenditure that has been allowed for in setting the tariff rates.

The risk of inflationary price escalation can be covered to some extent by indexation of power sales prices in line with the anticipated rise of running and rehabilitation costs. Indexation has to be forward looking but the only guide to indexation rates is the inflation rate experienced at the particular time. The indexation rate cannot give precise compensation because future price formation remains unknown and because the price rises to be protected against will not necessarily correspond to current average inflation rates in the economy concerned. Indexation may be held back by government policy restricting the rise of electricity prices or by consumer resistance. Both public and private operators of an electricity supply system may then face the risk of receiving inadequate compensation for increasing costs of supply unless periodic adjustment of indexation rates can be achieved.

Interface Risks

The risks attending project promotion by the private sector depend greatly on the status of the initial developer and on the time of change-over of management and ownership from the developer to the ultimate owner/operator. Three cases present themselves:

1. If the project is developed by the public hand, the public-private interface will not come into play until the project is transferred to the private party. The common risks are carried by the public developer, with an interface risk arising at or after the time of transfer;
2. If the plant is developed by private enterprise and ultimately transferred to the public sector (the BOT concept), the private developer will have to face both the common and the interface risks, but the latter only up to the time of transfer;
3. If the plant is developed by and remains in the private sector, the private developer and owner will have to face the full range of common and interface risks throughout the life of the plant.

The principal interface risks are outlined below.

Political Risks

The non-governmental party will at all times be exposed to whatever policy may cover its operations. To enter the field of electricity supply at all, the private party must have received sufficient encouragement through enabling and liberalization measures, assistance with licensing, allocation of rights for water use and power sales, full protection of private property and assurances of continued long-term support. There could be a risk that the measures offered were coloured by short-term considerations - by the immediate needs of government, and that they may become more restrictive in the long run, perhaps in the light of a changing political climate. Governments and people may also gradually become accustomed to the benefits that private developers have brought and may not wish the developer to draw permanent, or what they may see as excessive, advantage from the service he has provided; they may then want to throttle back on the opportunities they had originally created. The risk is greatest in the case of a fully private-sector operation (case (3)) and can perhaps be better contained:

• where a plant is ultimately transferred to the public sector, particularly if the intervening period of private operation is short;
• where a plant is ultimately transferred to the private sector, at which time government policy, or changes in it, may be clearer.

The private developer can secure some protection through bilateral and multilateral investment insurance agencies (export credit or investment guarantee agencies) and also through direct involvement of governmental or quasi-governmental bodies in his project, for example through co-financing and corresponding risk-sharing. Complete protection can probably not be achieved and a residual risk, especially with equity participation, is likely to remain.

Financial and Commercial Risks

As opposed to political risks, the financial and commercial risks touch essentially the investment and profitability profiles of a private-sector enterprise in a somewhat restricted economic environment. Investment pressure on capital markets often exceeds the scope and willingness of these markets to respond. Scarcity of investment capital has caused the public sector to look for funding support from private sources but there are two pre-conditions to be met:

• the project must be attractive to the private investor and meet his financial objectives;
• any risks to which the private investor may be exposed must be containable.

Financial and commercial risks can be mitigated by spreading project funding over different investors and different markets and by securing public-sector co-funding as well as public-sector underwriting of the viability of the project. The private investor will look for a sufficiently comprehensive range of enabling and liberalization measures that will permit him to operate satisfactorily under the particular conditions prevailing in the country. The risks he may face depend on his residence status; a foreign investor will inevitably incur greater risks. The principal risks and mitigating measures are the following:

Taxation

Tax on profits, social contributions and investment allowances must be supportive to private investment and must pay heed to the type of service the investor is to provide, especially by way of guarantees for the longer term. Governments may wish to use taxation rather than regulation as a means of controlling the profitability of the undertaking but this will hit the electricity consumer unless electricity rates are pitched at a level at which the enterprise cannot remain commercially sound.

Fees and Rates

Licence fees or other conditional public contributions can discourage private enterprise and can form a risk if they are on an upwardly escalating scale. The rates at which power is permitted to be sold by a private generator are critical for his commercial performance. Government intervention on rates is experienced in many countries and can form one of the principal, and recurring, matters of dispute between the public and private sectors. The concept of 'permitted return' is common even in economically advanced countries and is one of the risks from which the private investor is unlikely to escape. His remedy is to structure his financial input to the project in such a way that his exposure to profitability regulation is minimized. The risk to which any non-governmental operator of a power generating or distributing facility cannot fail to be exposed is sometimes also termed a pricing or revenue risk and results from different conceptions of what is a 'reasonable return'. Prior to private-sector involvement, rates of stand-alone schemes in isolated areas were often subsidized directly by the public purse or indirectly from revenue surpluses of centralised areas or by cross-subsidization. Consumer reaction will naturally be adverse once such subsidies fall away and pressure will be brought on the government to regulate for rates to be brought back to their subsidized level. Direct participation of consumer groups in isolated schemes can help in such situations by bringing about awareness of the need to replace subsidies by higher electricity charges, i.e. to replace social pricing by some form of commercial pricing.

Regulation

Electricity supply is considered by governments and the public to be a public service, whoever the supplier. It is inevitably a monopoly, at least as far as the small consumer is concerned. The conditions under which the supply is given are therefore regulated in both a technical and a commercial sense. The supplier runs the risk that the regulatory conditions will change from time to time, not necessarily in response to the quality and cost of the service provided but conditioned by externalities, economic and fiscal policies for example, or indeed by the political climate. Regulation can impose a serious and generally unpredictable risk for a private-sector operation, especially where regulation is in danger of becoming increasingly restrictive as the benefits achieved by the private operator become more apparent.

Foreign Exchange

Monetary transactions across national boundaries are subject not only to the financial risks attending currency conversion but also to the risks imposed by governmental exchange controls in countries suffering from restricted currency convertibility. Exchange risks affect foreign suppliers of goods and services as much as they do local importers. Clauses protecting against such risks are common in export/import contracts. Financial arrangements such as forward purchases of foreign exchange can also give some protection against currency fluctuations. The risk increases as the involvement of the foreign party becomes more protracted, not only due to unforeseen currency movements but also to the danger of government intervention in protection of the home currency. Such intervention, through exchange controls for example, could restrict currency conversion and export and could make it difficult to redeem investments and service loan or equity capital. Cooperation with bilateral and multilateral funding agencies, or conjoint funding with them, can offer some protection to a foreign investor; he will no doubt be aware that currency export liberalization policies of host governments can and do change with the economic situation of the country.

Legislative and Legal Risks

Entry of a non-governmental party into a government-owned and controlled industry is not possible unless the government opens up the industry through appropriate legislation, or at least implements the already frequently mentioned 'enabling measures'. To what extent such measures can simply be expressed in statements of intent or published policy documents or have to be enshrined in legislation depends on the statutory situation in the particular country; it depends also on whether the government wishes to make a single exception by admitting say a single BOT deal or whether it is to be an across-the-board opening up of the industry. Nevertheless, electricity supply has become an essential part of the national infrastructure in all countries and it affects a large and growing proportion of the population. Governments are therefore anxious to ensure that whatever standards may have applied to the public sector industry are maintained by the private sector. Indeed, governments expect that the new influx of funds will result in standards to be raised. Non-governmental parties will expect their entry into the industry to be subject to a series of governmental constraints expressed through legislation or law. They must accept the risk that government perception, and hence legislation or law, may change in time and may have an adverse effect on their operations by becoming more restrictive. The situation in industrialized countries has shown that there is an ongoing debate between the public and private sectors over the way in which regulations are interpreted and operations are carried out, and sometimes also perhaps a lack of understanding of the role of one of the parties.

Particular points at issue include the following:

• the effectiveness of government guarantees, bearing in mind that many governments have a transient life;
• the maintenance of technical and performance standards which may have become outdated or inappropriate for a commercially-motivated operation;
• the employment policy which the private hand may have to sharpen considerable in order to remain profitable;
• the liabilities imposed by public utility operation which may unduly restrict the actions of a private operator;
• the maintenance of safety standards which may inhibit updating of operational procedures;
• the assessment of environmental impact which may be seen in different light by the two parties.

These matters require resolution through cooperation between the public and the private hand but they can impose serious risks for the success of a private venture if they are not effectively dealt with.